Features of Structured Products in the evolution of the Sukuk structure

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In recent times, where there have been many economic downturns and the stock market value has been battered, investors are more demanding when it comes to the features of the investment products that are offered to them. Effectively, investors nowadays would like the best of both worlds where they would be given some assurance that their capital will be preserved and at the same time they would like to have the chance to receive generous amounts of returns. Various investment banks have undertaken the effort to pioneer such a product that will appeal to both institutional and also retail investors.

Commonly known as a structured product, it is essentially a single product that combines a few different asset classes or market strategies. The aim of the structured product is to give the investors the best that the market can offer. For an easy description, if we refer to the old adage “never put all your eggs in one basket”, the structured product is the exact opposite of that. In the structured product, each egg is placed in a different basket to attract different prices/yield. The net result of this would be the higher than average return with a low to moderate risk profile.

These structured products that are in the market have two main features that appeal to a wide spectrum of investors. The first one is the principal guarantee feature. Most structured products will have a high portion of its investment (between 60-80 percent) placed in highly rated low risk bonds where the yield offered will allow a portion to grow back to the original amount of the principal at the maturity of the structured product. This is how the principal amount is being protected. For example, if the amount invested by the investors in the structured product is RM100, RM80 will be invested in a portfolio of low risk bonds that will yield a 10 percent annual return. Assuming the tenure of the structured product is 3 years, by the end of year 3 the amount of funds shall be RM104. As a result, investors now have their principle back and have gained a profit of RM4.

The second feature is the “kicker” element. This is where the remainder of the funds in the structured product will be invested in high risk and high yield instruments. As the principal of the structured product is already secured, the manager has a free hand in taking on more risk in pursuit of higher yield.

How would both of the features above relate to the Sukuk market you may ask? Essentially, investors in the Sukuk market share similar characteristics with the investors of the structured product. The Sukuk investors require that their capital be safe while also wanting to enjoy a reasonable return.

Quite recently, we have seen the evolution of the Sukuk structures in the market that incorporated both the structured product features as explained above. A hybrid Sukuk structure such as the Gulf Investment Corporation Sukuk Wakalah Bil Istithmaar used a combination of the Murabahah and the Wakalah contracts to achieve the same effect as would be achieved by a structured product. The Gulf Investment Corporation Sukuk Wakalah Bil Istithmaar is a RM 3.5 billion Sukuk program that was rated AAA by the Rating Agency of Malaysia (RAM).

Firstly, a Murabahah contract is used to create the indebtedness between the SPV 1 that is owned by the Issuer with the Issuer also acting as an agent to the investors. The commodity Murabahah shall be transacted between these two parties where the Issuer acting as the agent to the investors shall sell commodities to SPV 1. The final selling price (which will include a mark up) shall create an indebtedness that will be equal to the amount of the Sukuk and its outstanding yield. This Sukuk structure is taking a leaf out of the book of the structured product by securing the obligation of the Issuer via the obligation of SPV1 (which is owned by the Issuer).

Next, the Issuer that is acting on behalf of the investors shall enter into a Wakalah contract with SPV2. The fact that the Sukuk obligation has been secured through the Murabahah transaction earlier between SPV 1 and the Issuer acting as an agent to the investors allows the “kicker” portion of the Sukuk to be invested through a Wakalah contract which is riskier than that of a Murabahah.

Investors of the Sukuk that is described above will be in an advantageous position where should the investment activities in the Wakalah leg turn bad, they will still have a very concrete recourse to the issuer through the Murabahah leg of the Sukuk.

In essence, the structure of the Sukuk has evolved to keep up with the investors’ demand in the market in order to compete with its conventional bond counterpart. Having incorporated the elements of a structured product in its structure will only add to the appeal of the Sukuk. The success of the Gulf Investment Corporation Sukuk Wakalah Bil Istithmaar (both tranches issued have been oversubscribed so far) is proof that the market is positive about the new Sukuk structures.

About the Author

Baiza is a graduate of Monash University, Australia with a degree in Business Studies double majoring in Accounting and Economics. He is an Islamic Capital Market consultant with 12 years experience in various fields within the Islamic Finance industry. He started his career as research associate with Islamic Financial Data Services Ltd. (U.K) specilizing in Islamic finance and banking data research before joining IslamiQ Ltd. where he was instrumental in developing the ScreenIslamiQ, the online service that allowed users to access information on Shariah compliant stocks in the major global stock markets. Baiza was also involved in the IslamiQ advisory team that completed the Shariah structuring of a US$150 million Islamic private equity fund focusing on dynamic and undervalued Asian companies.